Predicting inflation rates can be a difficult task, especially when an economy is in a volatile state. You can use Treasury Inflation-Protected Securities (TIPS) to figure out future inflation using some simple math. Learn how to make TIPS inflation calculations and what their strengths and weaknesses are.
What Are TIPS?
TIPS are Treasury notes whose amount goes up with inflation and goes down with deflation. The securities' value adjusts after the Consumer Price Index (CPI) adjusts. The CPI is the most common way to measure inflation.
Like a plain Treasury note (T-note), TIPS provides people who invest with a semi-annual interest payment that has a fixed rate. The interest payment is found by using the adjusted value of the bond. This payment goes up with inflation. It would go down in the rare case of deflation. The amount of money you receive is the original amount you put in adjusted for inflation. In short, the amount of money rises or falls with the CPI. The coupon rate is your "real return," or return above inflation.
TIPS can trade with a negative yield. This has happened at times when the Federal Reserve has kept its policy rate low.
Plain T-notes carry no such inflation protection. Since a T-bond investor is fully exposed to the impact of inflation on the bond, they demand a higher interest rate. This could be looked at as a hedge against inflation.
Figuring Out Future Inflation With TIPS
You can figure out a risk premium by looking at the contrast in yields on a T-note and TIPS that have similar dates when they mature. The result shows the amount of inflation protection investors need by showing what inflation rate to expect in the future.
For instance, if the five-year T-note has a yield of 3% and the five-year TIPS have a yield of 1%, the inflation you might expect for the next five years would be roughly 2% per year. Using two- or ten-year issues would give you the expectation, or outlook, for those times. This difference is often called the "break-even" inflation rate.
The math for the inflation rate to break even is shown below.
If you want to know what T yields might look like in the future, given an expected inflation rate, you can tweak the math.
The same could apply if you want to know about TIPS yields with a given breakeven inflation rate.
Using this method, you can easily find the market's outlook for the future inflation rate. The concept of using an inflation rate to break even is only a theory. This is because the differences between the two securities lead to market changes that prevent this math from giving an exact result.
Factors That Impact Expected Inflation
The TIPS trading volume is much lower than that of T-notes. The yield can often change due to factors that do not relate to what inflation might be in the future.
One of the largest factors that affects the price of given and real yield securities is the inflation outlook by those who invest. This leads to changes in the extra amount of money they are willing to pay for either type of T-notes.
For instance, if those who want to invest money expect the inflation rate to break even for T-notes to be 1.8% and expect inflation to stay at the Fed's target rate of 2%, they would buy TIPS. If the rate to break even were higher than the expected inflation, they may choose to invest in something else. In essence, this method means you are making a bet for or against the rise of inflation.
When those who invest try to beat inflation, they create changes in prices and interest rates due to the changes in demand they induce. This could undo their attempts to lower the risk of inflation.
Studies also show that some inflation outlooks are too high. A few methods are being looked at to get to a more exact number. One way of doing so takes liquidity into account. Break-even inflation is not a perfect method of looking at future inflation rates. It does remain another tool in an investor's toolbox. It can help with finding out what risk and reward might be seen in the future.
ETFs That Track Break-Even Inflation
There aren't many funds or investment types that track or use the rate to break even. The RINF tracks the TIPS-Treasury spread with no leverage. The share price of this fund should rise when expectations go up. Those who invest can trade inflation outlooks since this ETF tracks the gap between 10-year T-notes and 10-year TIPS.
Don't feel bad if this is a lot to take in. Try the math a few times and see if it makes more sense. It's one of the many things that people who want to put their money to work for them look at when making those choices.
- TIPS are bonds that tweak their interest rates to account for changes in inflation.
- By taking away the TIPS yield from the T-note yield, you can figure out what inflation rate you might expect.
- You can use this math with any term length, and the result will give you the inflation to expect for the length of those bonds.
- The ProShares Inflation Expectations ETF (RINF) tracks the expected inflation for the 10-year T-note and 10-year TIPS.